Apartment Investing and The (Other) Golden Ratio
While most of my active real estate efforts go towards rehabbing/flipping houses, I’m a huge fan of investing in apartments. I’ve done some passive investing in the past (invested in other people’s projects) and am always on the looking for great apartment deals to add to my portfolio.
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Why do I love apartment investing so much? It’s all about what I call the Golden Ratio…
You may have heard references to the Golden Ratio in mathematics and architecture, but that’s not what I’m referring to here. I’m referring to the other Golden Ratio – the one that applies to income-producing real estate investments. You probably won’t see it referred to as the Golden Ratio anywhere else, but this is what I call it, because it’s worth so much.
The Golden Ratio in apartment investing is about 10 to 1 (10:1). This is the ratio between the amount of extra value you get out of your apartment investment for every extra dollar of income your property brings in.
In other words, for every $1 of extra income your property produces, the value of your property increases $10! Let’s take a look at why that’s the case…
If you have ever studied some basic financial analysis of income producing properties, the value of a property is directly proportional to the amount of net operating income (NOI) it produces:
Price = NOI / Cap Rate
(This is just a rearrangement of the Cap Rate formula: Cap Rate = NOI / Price)
So, if a typical property has a cap rate of about 10% (which is a pretty realistic average), then for every $1 of NOI the property generates, the property is worth $10.
For example, let’s say a property with a cap rate of 10% has an annual NOI of $1000; using the formula above, the property is worth about $10,000 (Price = $1000 / 10% = $10,000). Now let’s say that same property is able to increase its annual NOI to $1100; now its price increases to $11,000 (Price = $1100 / 10% = $11,000). That extra $100 in income translates to an extra $1000 in property value (a 10:1 increase).
And remember, when we talk about NOI, we’re talking about the total income after expenses. So, for every $1 you can shave off expenses, you get the same $10 increase in property value. For example, if you can cut your annual property taxes by $500, your property value will have just increased $5000.
Pretty cool, huh? Now you know why I love apartments…